The process of buying a business jet is fraught with potential pitfalls, among them the many ways that owners can fall afoul of legal constraints. The 2014 NBAA Tax Seminar & Conference, held last month in San Francisco, offered a one-day summary of the issues facing aircraft owners, not only summarizing the key problems that can develop but also giving participants a foundation for understanding how best to set up a flight department from a legal standpoint and how to satisfy taxing authorities with the minimum hit.
Glenn Hediger, president of Aviation Financial Consulting and a member of the NBAA Tax Committee, began the day’s sessions with an update on current NBAA Tax Committee activities and issues. The extension of bonus depreciation is a hot topic, and while the Senate Finance Committee passed a two-year extension of expired provisions that include bonus depreciation, the House Ways and Means Committee didn’t include it in a recent extension of some expired provisions. “So the House and the Senate are very much disconnected on the path of how they approach the tax extenders,” Hediger explained. “We’ll see what happens. No one’s really expecting any action on the tax extenders until after the midterm elections, so we’ll probably see something in late November or December.”
The government has made no progress on closing the so-called “corporate jet loophole,” which would, he said, change the depreciation life to seven from five years, the same as is used for commercial aircraft. “Currently it’s not part of any legislative proposals,” he said, “but it is often discussed as a [payment] for any tax relief that’s out there. NBAA is keeping its eyes on that. It’s not a large dollar generator for the government, but it is a popular item to throw into the [mix].”
At a meeting in late April, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board held a meeting to discuss an ongoing convergence project on how leases are accounted for. “If you’re leasing your aircraft or leasing any assets in your business, you should be conscious of the developments here,” Hediger said.
According to the FASB, “The existing accounting models for leases require lessees and lessors to classify their leases as either capital leases or operating leases and to account for those leases differently. Those models have been criticized for failing to meet the needs of users of financial statements because they do not always provide a faithful representation of leasing transactions. As a result, there has been a widespread request from users of financial statements and other stakeholders to change the accounting guidance so that lessees would be required to recognize assets and liabilities arising from leases.”
Hediger added, “There has been a change in leadership at the FASB, and not all of the new leadership are in favor of [these] sweeping changes on lease accounting. Most lenders and readers of financial statements understand the footnotes and disclosures on leases that are currently there. There are more meetings scheduled, and adoption is probably not going to happen until fiscal year ’16 or ’17. But it’s something to keep on your radar screen if you have a leased aircraft. It’ll be a big item on your balance sheet and certainly it could change the financial ratios when you’re looking at your debt and equity.”
Aero Law Group founder Kevin Austin summarized the challenges facing the approximately 130 attorneys, accountants and aircraft operators in the NBAA Tax Seminar, comparing all the regulatory and tax issues with the game Whac-A-Mole, where each time the player knocks a mole back into its hole, another mole pops up elsewhere. Austin’s game board has mole holes for the dizzying array of federal and state taxes, disallowance of deductions for entertainment use of the aircraft, leasing and charter activities, disclosures to shareholders and the Securities and Exchange Commission and more. “We try to balance those subjects,” he said. “We’ve got to deal with one of the moles, we plonk one down and the other one pops up.”
Austin’s presentation focused on the various ways that business aircraft can be operated under FAA regulations and the effect these methods may have on how the Internal Revenue Service (IRS) views the operation.
A typical scenario sees a company buy an aircraft then form a separate limited-liability company (LLC) to own and operate the aircraft. “From the FAA’s perspective,” he explained, “if the LLC has only the aircraft and the pilots, it cannot operate the aircraft under Part 91.” The risk here is that the FAA could determine that the LLC is a commercial operator subject to operating under Part 135 charter regulations. This may also be a violation of insurance coverage, breach covenants in a lease or loan, subject the asset to a longer depreciation schedule and subject the aircraft to federal excise taxes (FET), he pointed out.
While it might make sense to use a sole-purpose company structure (LLC) to minimize sales taxes or when planning to have the aircraft operated by a third party such as a flight school or charter operator, some owners might find themselves in the position of having set up the LLC structure without knowing the consequences. In this case, Austin said, “Our recommendation is to lease the aircraft back through a dry lease [without pilots].” In this case, the LLC would be the aircraft owner and the company would be the operator of the aircraft.
Austin outlined the eight limited exceptions to the Part 91.501(b)(5) rules on reimbursement for flights and pointed out that reimbursement doesn’t just mean that cash changes hands. In the FAA’s view, anything of value can substitute for cash and thus turn the flight into a commercial operation, subject to more stringent operating rules and also possibly FET.
The exceptions can be confusing, too, and he cited the example of a parent company receiving internal reimbursement by a subsidiary for flights conducted for the subsidiary. This can be done, and there is no issue if the subsidiary is 100-percent owned by the parent company. An 80-percent-owned subsidiary might quality, he said, but this begins to get into the “maybe” area. If the parent owns 51 percent of a subsidiary or an entity is a subsidiary of a subsidiary, then the FAA exemption is not being met.
Of course, per the regulation, the following applies to the reimbursement amounts: “no charge, assessment or fee is made for the carriage in excess of the cost of owning, operating and maintaining the airplane, except that no change of any kind may be made for the carriage of a guest of a company, when the carriage is not within the scope of, and incidental to, the business of that company.”
Austin warned attendees about the so-called “Part 134½” abuse of dry leases. “Hourly leases are troublesome,” he pointed out. “The FAA really wants to see the pilot come from an independent source.” If the lessee hires its own pilot from a truly independent source and clearly has operational control of the flights, then there shouldn’t be any legal issues. But any questionable behavior, such as hourly leasing and a lessee that doesn’t have operational control (knowledge of flight operations, airworthiness and flight crew eligibility), is risking an illegal charter. And this could be an issue for insurance coverage, too, Austin said.
Referring to the infamous crash of an illegally chartered Challenger during takeoff from Teterboro in 2005, he said, “Platinum Jet got to the level of criminal fraud. This was really an egregious case.” If an aircraft and pilots are being provided by one party to another and payment is being exchanged, he added, “that’s a red flag.”
Flying and Taxes
A key focus for the NBAA Tax Seminar was sessions on state sales and use taxes (which primarily covered California and Washington, given the venue of the meeting in San Francisco), federal audit traps in leasing situations, reporting issue for public companies and FET. The seminar ended with two practical sessions, on best practices for managing non-business use of aircraft and case studies on gray areas of business aircraft usage.
“It’s a melting pot of planning disciplines,” said Keith Swirsky, president of GKG Law, “and for those of you who are users of aircraft, you can’t engage one advisor to do the sales and use tax, another advisor to give you the federal tax, and somebody else who may be doing the FAA planning; it doesn’t work. It has to be an integrated, harmonious scheme of planning or it’s just going to fail in one area and be a gotcha–‘Oh my, I didn’t think about that because the advisors didn’t get together.’”
Swirsky explained the differences and tax implications between Internal Revenue Code 469 (passive activity losses) and 162 (trade or business expenses and whether the aircraft is an ordinary, necessary and reasonable business tool) and how these might apply to a particular operation. To ensure proper preparation for tax consequences for Code 162 trade or business expenses, Swirsky recommends a comprehensive business plan that details reasons for owning and operating a corporate aircraft. The business plan should address why the particular type was selected; how the aircraft will help the business grow; plans for chartering, if applicable, which is a for-profit motive that can help with tax implications; the aircraft as a tool for retention of key personnel; increased productivity; and enhancing the safety and security of key personnel.
During the session on best aircraft reporting practices for public companies, attorney Stuart Lapayowker, who is chair of the NBAA Tax Committee, summarized the enormous complexity facing aircraft owners. “The problem is that the FAA, the IRS and the SEC do not speak the same language.”
Although the FAA doesn’t allow Part 91 operators to accept compensation for transportation, with limited exceptions, he explained, when using an aircraft for non-business use “the IRS position is that it’s a fringe benefit. If it’s a fringe benefit, someone needs to pay for it, and that’s typically the employee, and the income needs to be imputed to the employee’s income. The SEC comes from a completely different perspective. Their perspective is transparency and disclosure. They don’t really care what the FAA’s rules are and how you’re limited in reimbursing. They don’t care what the IRS says the value is or income imputation or fringe benefit value purpose is. They want the shareholders to know what the company is spending on these things.”
Lapayowker explained the two formulas the IRS uses to calculate reimbursements for personal non-business use of company aircraft, and he emphasized that the chosen formula must be used consistently. The formulas are the standard industry fare level and fair market value, which he noted is essentially the value of a charter.
At the end of the presentation, Alvaro Pascotto, who shared the podium with Lapayowker to explain the intricacies of SEC reporting, summarized the complexities of the subject: “I recommend counsel that can help you,” he said. It was clear from this and most of the other presentations that flight departments need to set up systems to record nearly every detail of each flight, including who traveled where and for what purpose, to be prepared for a possible IRS audit.
The Thorny Issue of Federal Excise Taxes
The issue of the IRS assessing Part 91 operators the 7.5-percent FET that is normally required of commercial operators was a highlight of the afternoon session. Mark Dennen, CFO at charter/management provider Solairus Aviation and a member of the NBAA Tax Committee, summarized the history and current status of how the FET is being applied to management companies.
While earlier IRS revenue rulings and private letter rulings seemed to follow the FAA categorization of Part 91 flights as non-commercial operations on behalf of the owner and Part 135 as commercial flights subject to FET, in March 2012 the IRS unveiled a chief counsel advice (CCA) memo that “kind of rocked the industry,” he said. “Looking at Part 91 traditional flight activity in the context of a managed operation, [the IRS] began to focus almost exclusively on who paid for the pilots. It concluded that employing the crew meant that the management company was providing air transportation and it began assessing FET on Part 91 management operations–something that had never been done.”
The CCA pointed the way for IRS agents to audit management companies and require them to assess FET on every charge that the management company bills to aircraft owners. This includes management fees and, according to one member of the tax seminar audience, the IRS even required the company to pay FET on engine maintenance program fees and other services billed to the owner.
The central issue, at least in the IRS’s opinion, revolves around who has possession, command and control of the aircraft. “[Part] 91 flights performed under management services had historically been non-taxable since the 1950s,” Dennen explained. “For nearly 50 years the IRS has held that management companies are not providing transportation to owners as long as the owner hasn’t relinquished possession, command and control of the aircraft to the management company and that the management company is acting as an agent for the owner.”
A technique guide developed for IRS auditors several years ago, according to Dennen, attempted to clarify when an aircraft owner relinquished possession, command and control. The easy answer was to look at who paid the pilots and for maintenance, who does the scheduling and flight planning and so on. “They’re saying if a management company does those things that they’re providing transportation for the owner of the aircraft,” he explained, “which just doesn’t make sense to a lot of us in the industry.”
The 2012 CCA underscored that guide, claiming that by merely employing the pilots, the management company controls the pilots and thus controls the aircraft and therefore is providing air transportation that is subject to FET. “They said that the management company was exercising virtually all decision making,” Dennen said. “I don’t know how they got that the management company is making the decisions. They schedule the flights at the owner’s request to go where the owner wants to go with the owner’s passenger on board. But [the IRS] said the owner only had authority limited to selecting flight destinations. Well, they did, but whenever and wherever they wanted to go. So we’re still scratching our head on this one.”
NBAA and the National Air Transportation Association have met with the IRS, including the chief counsel’s office, to try to resolve the FET issue. Last year, the IRS agreed to suspend any audits on aircraft owner flights. This was followed by the IRS notifying the aviation industry that the FET issue would be placed on its priority guidance list, Dennen said, “so it’s on their list to address that with us.”
For those management companies that did get audited, most cases were appealed, he said. “And what I’m told by folks on the [tax] committee who represent clients is that at the appeals level almost all of them are getting settled in favor of the taxpayers.”
Meanwhile, Dennen provided best-practice suggestions for management companies to set up agreements with aircraft owners to avoid having to pay unnecessary FET. These include a separate dry-lease agreement for Part 135 flights; providing all services as an agent for the owner and letting the owner participate actively in pilot hiring, choosing insurance coverage, maintenance decisions, selection of flight planning and passenger support services and so on. “The owner should have the right to provide any and all of those above services on his own,” he said. “In a true agency agreement he’s hiring [the management company] to help him. When you’re acting as an agent, you’re acting on behalf of the owner.”
Dennen also recommended short-term service agreements with maximum 30-day cancellation clauses. The owner must have access to the aircraft at any time and also approve or disapprove every charter request. Hourly charges might be a red flag, and the agreement should reflect that the owner is paying all actual operating expenses for the aircraft. Separate bank accounts for each owner are also a good idea. “The owner sets it up in his name at our branch,” he said, “and we pay all his bills out of his account with his money. So we’re not charging him for anything. We’re truly acting as an agent. And we don’t send a bill. We send the statement, and the statement is [telling the owner to] put more money in your account because this is what just went out of the account.”
The bottom line, Dennen concluded, is that “you really have to look at all the facts and circumstances to make sure that you’re not setting yourself up for something that could become taxable or, worse, an illegal charter operation if the FAA were to take a look at it.”